Upswing poses questions for Fed

By Neil Irwin
Washington Post Staff Writer
Wednesday, December 16, 2009

When Federal Reserve policymakers finish their two-day meeting Wednesday afternoon, the big question hanging over them will be what an improving economy means for central bank policy.

The Fed is almost certain to announce that it will leave its target interest rate near zero and keep that rate very low for an extended period, as has been its policy for the past year. The unemployment rate, after all, was 10 percent in November, and both Fed leaders and private economists expect joblessness to remain high for quite some time.

But in their assessment of the economy -- and the outlook for policy -- members of the Federal Open Market Committee will be adjusting to an economy that seems to be gaining momentum. Job losses came to a near halt in November and the unemployment rate dipped a bit, while retail sales last month rose more than expected. On Tuesday, the Fed said industrial production rose 0.8 percent in November, better than expected, suggesting that the manufacturing sector continues an expansion that began over the summer.

Those positive developments could prompt Fed leaders to upgrade their assessment of the economy in their statement scheduled to be released at 2:15 p.m. Wednesday. The gains also could also make them more comfortable with winding down unconventional efforts to prop up the economy -- other than ultra-low interest rates -- and bolster arguments of inflation worriers on the committee, including the presidents of some regional Fed banks who are eager to end the most aggressive policy steps.

"The policy that's in place was put there when we were in a deep, sharp recession and afraid of something much worse," said Alan Levenson, chief economist at T. Rowe Price. "As the economic environment improves, that stance becomes inappropriate, and may carry risks of its own."

A program to buy $1.25 trillion in mortgage-backed securities is scheduled to wind down by the end of March, and some programs to support specific credit markets have fallen into disuse. Another step the Fed could take in the next few months would be to raise the rate at which banks take out emergency loans, called the discount rate, while leaving its main policy tool, the federal funds rate, near zero.

That said, top Fed officials are far from confident that the economy is out of the woods, and are unlikely to risk causing a return to recession so long as inflation pressures remain distant. Just last week, Fed Chairman Ben S. Bernanke said that his "best guess" is that "we will continue to see modest economic growth next year -- sufficient to bring down the unemployment rate, but at a pace slower than we would like."

Fed leaders have tried in recent weeks to lay out the circumstances under which they would consider raising rates -- not so much to answer the question of when they will do so, but to explain what economic conditions would provoke an increase in their target for the federal funds rate, which has been zero to 0.25 percent since December 2008.

The key things they're watching include slack in the economy, as measured by such indicators as unemployment and capacity utilization in the industrial sector, inflation, and expectations of future inflation.

While the jobless rate dipped and capacity utilization ticked up in November, both measures still indicate that the economy is functioning well below its potential. Inflation has been generally well contained, though the Labor Department said Tuesday that wholesale prices rose a greater-than-expected 1.8 percent in November, driven by higher fuel prices. Inflation expectations have been little changed in recent weeks.

To most Fed watchers, those realities, combined with recent speeches from Bernanke and other top central bank leaders, suggest little reason to think that major policy changes are on the way.

"The tone of the data has greatly improved, but it's fair to say that Ben Bernanke has shown some of his cards," said Anthony Chan, chief economist for J.P. Morgan Private Wealth Management. "He's been saying that the economy is still sort of weak, which justifies keeping rates low for an extended period."

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